Risk aversion keeps too many people out of the investing game. The practical outcome is a limited opportunity to build wealth and realize financial independence. Rather than outperforming inflation with a well-rounded portfolio, you accept a minimal or negative return on cash savings with no real chance to get ahead.
If that describes you, it’s time for a change. The first step is demystifying investment risk so you can manage it as easily as looking both ways before you cross the street.
Types Of Investing Risk
Losing money is a common fear among would-be investors. But risk is more nuanced than a decline in your account balance. Here are some points to demonstrate:
- Your cash savings balance rises as you earn interest. However, the account balance is less important than the money’s purchasing power. And the purchasing power of your cash savings is continually shrinking due to inflation.
- You can buy a stock for $10 and watch its value rise to $20, before falling back to $15. Did you gain or lose?
- You can invest in a stock that loses 10% over the next year. How you interpret that change depends on broader market performance. If the market gained 5%, your 10% loss is tragic. If the market lost 20%, your 10% loss is a win.
- Say you choose between two investments. The one you pick grows 10% and the other grows 20%. Did you gain or lose?
In other words, there are different ways to lose on an investment. Inflation can undermine your returns, your expectations about the asset’s performance can change, or a stock can tank due to factors unrelated to the company’s core operations.
Accepting this broad view of risk is a healthy step towards becoming a confident investor. With acceptance, you can learn to recognize and manage different risk types—which is more fun than watching and hoping for a good result. You can start that learning now, with this review of five forms of investing risk that can slow your long-term returns.
1. Horizon Risk
Horizon risk is the potential for your investment timeline to change unexpectedly, which can leave you with assets that no longer suit your needs. If you have ever taken a hardship withdrawal from your 40(k), you have experienced the downside of horizon risk. You were investing for retirement, and then something prompted you to withdraw those funds early. Now your balance and your growth potential are far lower than they were previously.
Early liquidation of your investments is problematic because you miss future compounding opportunities. In investing, there’s no such thing as making up for lost time. When the timeline shrinks, you can put in more money or accept lower results. Worse, the timing of your liquidations may force you to accept lower-than-expected cash prices for your assets.
You can manage horizon risk by:
- Having a healthy cash balance on hand to cover emergency expenses. If you have an unexpected financial crisis, use the emergency cash before reaching into your investment account.
- Regularly reassessing your financial goals and adjusting as needed.
- Maintaining a diverse mix of assets. Low-volatility positions are less risky to sell on short notice. Growth positions can swing widely in value, so a poorly timed trade can cost you.
2. Equity Risk
Equity risk is the potential for a stock to lose value because of broader market or economic circumstances.
In April of 2025, the S&P 500 declined $2.4 trillion in one day after U.S. President Donald Trump announced the specifics of his tariff program. The decline was not related to a single company or industry. It was prompted by investor fear that the new tariff policy would severely limit future business profitability. This risk factor can also be categorized more precisely as political risk.
You can mitigate equity risk by diversifying your portfolio into non-equity assets. Stocks, bonds, real estate and commodities each react differently to macroeconomic circumstances. If your stocks lose value because the overall equity market is weak, your other assets will probably be more resilient.
3. Inflation Risk
Inflation risk is the potential for inflation to erode your investment returns. Fixed-rate securities are particularly prone to inflation risk. Say you own a long-term bond that pays you $10,000 in annual income. Every year prices rise, the purchasing power of the $10,000 declines.
Diversification can also help manage inflation risk. Stocks historically outperform inflation over the long-term. Commodities, real estate and gold can also do well during periods of high inflation.
4. Interest Rate Risk
Interest rate risk is the potential for a fixed-income security to lose value because interest rates changed. Interest-rate risk mainly pertains to fixed-rate intermediate- and long-term bonds.
Fixed-rate bonds lose value when interest rates rise and gain value when interest rates fall. This happens because investors do not want to earn less than the prevailing market rate. There will always be less demand for a bond paying 3% when similar bonds pay 5%. The lower demand causes the market value of the 3% bond to decline.
Bonds can provide important stability to a portfolio, so you may not want to avoid them altogether. Instead, you can mitigate interest rate risk by investing in bonds with different maturities via a bond ladder or bond funds. A bond ladder is a set of bonds with staggered maturities. You might have one maturity every six or 12 months, for example. If interest rates rise, you will only have to wait months, not years, to reinvest your funds in new, higher-rate bonds. You can also achieve maturity diversification by investing in one or more bond funds.
5. Sequence-Of-Returns Risk
The sequence-of-returns risk is the potential for the timing of investment returns to affect how long your wealth lasts. With respect to retirement accounts, the sequence-of-returns risk is closely related to longevity risk—or the chance that you will outlive your savings. Specifically, negative returns in your earliest retirement years can limit the lifespan of your savings.
Imagine if you had retired in 2008, when the S&P 500 fell 37%. If you had $1 million primarily invested in large-cap stocks, your portfolio value could have fallen by $300,000 or more before you took a single retirement distribution. Worse, each retirement withdrawal would require the sale of more shares at lower prices to raise the necessary cash. With fewer shares, the portfolio’s growth potential shrinks and remains lower even after stock prices recover.
You cannot predict or avoid stock market downturns, but you can manage sequence-of-returns risk. Try these strategies:
- Gradually raise your exposure to more conservative investments as you approach retirement. Your goal should shift from wealth creation to wealth preservation.
- Build your income portfolio. If you use investment income to fund retirement distributions, you don’t need to liquidate.
- Consider delaying retirement if your original schedule coincides with a major market downturn.
Diversify For Safety
Diversification can address various types of investment risk. And yet, billionaire investor Warren Buffett famously described diversification as protection against ignorance. He may have meant to discourage the practice, but there is another interpretation.
As a novice or part-time investor, you probably have another job and commitments that demand most of your attention. You don’t have Buffett’s resources or expertise. There will be things you don’t know and circumstances you could not predict. You may even make ill-informed trading decisions that would constitute “ignorance” in Buffett’s view. So what?
Diversification provides a cushion so you can invest without having to be right 100% of the time. It won’t prevent volatility, but it can shave off its sharpest edges. For the non-professional investor, diversification is like wearing a seat belt while driving—a safety precaution in case things don’t go as planned.
Also, investing in a diversified portfolio will deliver far better returns than not investing at all. So buckle up and get moving. You have riches to create.